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14. Money, Asset Prices and Economic Activity

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14. Money, Asset Prices and Economic Activity 14. Money, asset prices and economic activity How does money influence the economy? More exactly, how do changes in the level (or the rate of growth) of the quantity of money affect the values of key macroeconomic variables such as aggregate demand and the price level? As these are straightforward questions which have been asked for over 400 years, economic theory ought by now to have given some reason- ably definitive answers. But that is far from the case. Most economists agree with the proposition that in the long run inflation is ‘a monetary phenomenon’, in the sense that it is associated with faster increases in the quantity of money than in the quantity of goods and services. But they disagree about almost everything else in monetary eco- nomics, with particular uncertainty about the so-called ‘transmission mechanism’. The purpose of this essay is to describe key aspects of the transmission mechanism between money and the UK economy in the busi- ness cycles between the late 1950s and today, and in particular in the two pronounced boom–bust cycles in the early 1970s and the late 1980s. Heavy emphasis will be placed on the importance of the quantity of money, broadly defined to include most bank deposits, in asset price determination. However, in order better to locate the analysis in the wider debates, a dis- cussion of the origins of certain key motivating ideas is necessary. I Irving Fisher of the University of Yale was the first economist to set out, with rigorous statistical techniques, the facts of the relationship between money and the price level in his 1911 study of The Purchasing Power of Money. Fisher’s aim was to revive and defend the quantity theory of money. In his review of Fisher’s book for the Economic Journal,John Maynard Keynes was mostly friendly, but expressed some reservations. In his words, ‘The most serious defect in Professor Fisher’s doctrine is to be found in his account of the mode by which through transitional stages an influx of new money affects prices’.1 In the preface to the second edition Fisher summarized Keynes’ criticism as being the claim that, although his 281 Tim Congdon - 9781847206923 Downloaded from Elgar Online at 11/04/2020 07:48:27PM via free access 282 How the economy works ‘book shows that changes in the quantity of money do affect the price level’, it ‘does not show how they do so’.2 In other words, Keynes felt that Fisher had not provided a satisfactory version of the transmission mechanism. Fisher quickly responded to Keynes. In fact, he used the opportunity of the preface to the second edition of The Purchasing Power of Money to direct Keynes to pages 242–7 of another of his works, Elementary Principles of Economics,which had been published in 1912 between the first and second editions. In those pages, entitled ‘An increase in money does not decrease its velocity’, Fisher noted that economic agents have a desired ratio of money to expenditure determined by ‘habit’ and ‘convenience’. If ‘some mysterious Santa Claus suddenly doubles the amount [of money] in the possession of each individual’, economic agents have excess money bal- ances. They try to get rid of their excess money by increasing their pur- chases in the shops, which leads to ‘a sudden briskness in trade’, rising prices and depleting stocks. It might appear that only a few days of high spending should enable people to reduce their money balances to the desired level, but ‘we must not forget that the only way in which the indi- vidual can get rid of his money is by handing it over to somebody else. Society is not rid of it’. To put it another way, the payments are being made within a closed circuit. It follows that, under Fisher’s ‘Santa Claus hypoth- esis’, the shopkeepers who receive the surplus cash ‘will, in their turn, endeavour to get rid of it by purchasing goods for their business’. Therefore, ‘the effort to get rid of it and the consequent effect on prices will continue until prices have reached a sufficiently high level’. The ‘sufficiently high level’ is attained when prices and expenditure have risen so much that the original desired ratio of money to expenditure has been restored. Prices, as well as the quantity of money, will have doubled.3 Three features of Fisher’s statement of the transmission mechanism in his Elementary Principles of Economics are, ● the emphasis on the stability of the desired ratio of money to expenditure, ● the distinction between ‘the individual experiment’ (in which every money-holder tries to restore his own desired money/expenditure ratio, given the price level, by changing his money balances) and ‘the market experiment’ (in which, with the quantity of money held by all individuals being given and hence invariant to the efforts of the indi- viduals to change it, the price level must adjust to take them back to their desired money/expenditure ratios), and ● the lack of references to ‘the interest rate’ in agents’ adjustments of their expenditure to their money holdings.4 Tim Congdon - 9781847206923 Downloaded from Elgar Online at 11/04/2020 07:48:27PM via free access Money, asset prices and economic activity 283 These are also the hallmarks of several subsequent descriptions of the transmission mechanism. In 1959 Milton Friedman – who became the leading exponent of the quantity theory in the 1960s and 1970s – made a statement to the US Congress about the relationship between money and the economy. He recalled Fisher’s themes. After emphasizing the stability of agents’ preferences for money, he noted that, ‘if individuals as a whole were to try to reduce the number of dollars they held, they could not all do so, they would simply be playing a game of musical chairs’. In response to a sudden increase in the quantity of money, expenditure decisions would keep on being revised until the right balance between money and incomes had returned. While individuals may be ‘frustrated in their attempt to reduce the number of dollars they hold, they succeed in achieving an equivalent change in their position, for the rise in money income and in prices reduces the ratio of these balances to their income and also the real value of these balances’.5 Friedman has also emphasized throughout his career the superiority of monetary aggregates over interest rates as mea- sures of monetary policy. The claim that, in a long-run equilibrium, the real value of agents’ money balances would not be altered by changes in the nominal quantity of money was also a central contention of Patinkin’s Money, Interest and Prices, the first edition of which was published in 1955. Money, Interest and Prices exploited the distinction between the individual and market experiments in a detailed theoretical elaboration of what Patinkin termed ‘the real-balance effect’. In his view ‘a real-balance effect in the commodity markets is the sine qua non of monetary theory’.6 The real-balance effect can be viewed as the heart of the transmission mechanism from money to the economy.7 II Despite the lucidity of their descriptions of the transmission mechanism, the impact of Fisher, Friedman and Patinkin on the discussion of macro- economic policy in the final 40 years of the twentieth century was mixed. In the 1970s Friedman had great success in persuading governments and central banks that curbing the growth of the money supply was vital if they wanted to reduce inflation. However, his theoretical work on money was contested by other leading economists and did not command universal acceptance. By the 1990s the preponderance of academic work on mon- etary policy focused on interest rates, with the relationship between interest rates and the components of demand in a Keynesian income-expenditure model attracting most attention.8 When asked by the Treasury Committee of the House of Commons for its views on the transmission mechanism, Tim Congdon - 9781847206923 Downloaded from Elgar Online at 11/04/2020 07:48:27PM via free access 284 How the economy works the Bank of England prepared a paper in which ‘official rates’ (that is, the short-term interest under the Bank’s control) influenced ‘market rates’, asset prices, expectations and confidence, and the exchange rate, and these four variables then impacted on domestic demand and net external demand. In a 12-page note it reached page 10 before acknowledging that, ‘we have discussed how monetary policy changes affect output and inflation, with barely a mention of the quantity of money’.9 The links between money, in the sense of ‘the quantity of money’, and the economy were widely neglected or even forgotten. The relatively simple accounts of the transmission mechanism in Fisher’s Purchasing Power of Money and some of Friedman’s popular work were particularly vulnerable on one score. They concentrated on the relationship between money and expenditure on the goods and services that constitute national income, but neglected the role of financial assets and capital goods in the economy; they analysed the work that money performs in the flow of income and expenditure, but did not say how it fits into the numerous indi- vidual portfolios which represent a society’s stock of capital assets. As Keynes had highlighted in his Treatise on Money (published in 1931), money is used in two classes of transaction – those in goods, services and tangible capital assets (or ‘the industrial circulation’, as he called it), and those in financial assets (‘the financial circulation’).10 (Keynes’s distinction between the two circulations formed part of the argument of Essay 9, on the weakness of the textbook income-expenditure model, above.) The need was therefore to refurbish monetary theory, so that money was located in an economy with capital assets and could affect asset prices as well as the price level of goods and services.
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